The Tax Cuts and Jobs Act (TCJA) imposed a new limitation on deductions of business interest expense by certain companies. And the limit, found in Section 163(j) of the Internal Revenue Code, became even more restrictive in 2022 — especially for capital-intensive businesses.
As a business owner, you should determine whether the deduction limitation applies to your company. If it does, you’ll need to closely evaluate its potential impact on your tax bill and consider strategies for mitigating that impact, including potentially making an election to opt out.
Qualifying for an exemption
Sec. 163(j) doesn’t apply to “small businesses,” so the first step is to determine whether your company meets that definition. A small business is one that cannot be defined under IRS rules as a tax shelter and whose average gross receipts for the preceding three years don’t exceed an inflation-adjusted threshold — $29 million in 2023.
However, even if your gross receipts are under the threshold, don’t automatically assume you’re exempt. For one thing, you may need to aggregate your gross receipts with certain related businesses in determining whether the exemption applies. Also, the definition of “tax shelter” is surprisingly broad.
Watch out for tax shelter status
Regardless of your company’s level of gross receipts, it won’t qualify for the small business exemption from the limitation on deductions of business interest expense if it’s deemed to be a tax shelter. You might associate the term with shady tax-avoidance schemes but, as defined under the Internal Revenue Code and IRS regulations, it’s broad enough to include many ordinary and perfectly legitimate businesses.
Tax shelters include entities formed for tax avoidance or evasion purposes, but they also include partnerships and other pass-through entities if more than 35% of their losses are allocable to limited partners or “limited entrepreneurs” — that is, owners who don’t actively participate in management.
If your company is deemed a tax shelter under this definition, there may be strategies available to shed yourself of tax shelter status. For example, you could perhaps reduce the amount of losses allocated to limited partners or limited entrepreneurs to less than 35%. Alternatively, you could arrange for some of those limited partners or limited entrepreneurs to actively participate in the management of the business.
Calculating the business interest expense limitation
If your company isn’t exempt from the deduction limitation, then your business interest expense deductions in a given year cannot exceed the sum of:
- Your company’s business interest income,
- 30% of your business’s adjusted taxable income (ATI), and
- Your company’s floor plan financing interest.
Assuming your company doesn’t have significant business interest income or floor plan financing interest expense, the deduction limitation is generally equal to 30% of ATI. Keep in mind that business interest income and expense excludes investment interest income and expense.
ATI is generally equal to your taxable income, calculated without regard to:
- Nonbusiness income, gains, deductions or losses,
- Business interest income or expense,
- Net operating loss deductions, or
- The 20% qualified business income deduction for pass-through entities and sole proprietorships.
Initially, ATI was also calculated without regard to depreciation, amortization or depletion. But, for tax years beginning after 2021, those items are subtracted in arriving at ATI — limiting business interest expense deductions even further. Disallowed deductions generally may be carried forward and treated as business interest expense paid or accrued in the following taxable year. Special rules apply to partnerships and other pass-through entities.
Note that, to provide businesses with some relief during the onset of the COVID-19 pandemic, the CARES Act temporarily increased the deduction limit to 50% of ATI in 2019 and 2020. The act also permitted businesses to calculate the 2020 limit based on their 2019 ATI. Now that this temporary relief has ended and depreciation, amortization and depletion are excluded from ATI, many more companies are affected by the business interest limitation.
Opting out
Certain real property, farming businesses and construction companies are permitted to make a one-time, irrevocable election to opt out of the Sec. 163(j) limitation. Opting out can generate significant tax benefits, but it’s important to weigh these benefits against the potential costs.
Companies that opt out are required to depreciate certain business assets — including nonresidential real property, residential rental property and qualified improvement property — using the alternative depreciation system (ADS). Recovery periods under the ADS are longer, resulting in lower depreciation deductions. In addition, companies that opt out aren’t entitled to claim bonus depreciation on qualified improvement property, which includes many improvements to commercial buildings.
Whether the benefits of opting out outweigh the costs depends on your business’s particular tax situation and other circumstances.
Planning opportunities
Is your company affected by the business interest limitation? It’s a good idea to find out. Potential planning opportunities include opting out, relying more on equity financing and less on debt, or generating interest income to offset some of your interest expense (for example, by extending credit to customers). Consult your tax advisor to identify the right strategy for your business and for help carrying it out.
© 2023